The eurobond is the only way forward – But under what conditions?

2011-08-16

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The leaders of the so-called Franco-German axis are meeting today to discuss the future of the euro. Image source: Reuters

French President Nicola Sarkozy and German Chancellor Angela Merkel are about to meet today in Paris officially to discuss issues regarding ways of implementing the decision that was taken on the July 21 Euro summit, while unofficially they will also talk about the prospect of a joint eurobond. Many experts believe that the eurobond is the only viable option for European leaders at this moment and the only way to contain the crisis.

I am also aligned with that view though I maintain some reservations regarding the technicalities of this eurobond, since I believe that a flawed final structure just like the toxic structure of the EFSF which is the source of contagion, would have adverse effects as it would bring the existing contagion dynamics to the power of two. A flawed eurobond can be the Achilles heel not only of the euro, but also of the credit rating of triple-A rated economies of the European core.

The reason I say that is that the issuing of a joint eurobond, presupposes the mutualization of the system’s debt. Therefore the German dictum that has shaped decisions so far, that each country should pay for its own debts will be abandoned. What now is a series of sovereign debts, will become a single debt, meaning that all of a sudden surplus countries will have to carry a significant part of the burden of their indebted partners.

In practical terms this means that perhaps Germany and certainly France will put their triple-A rating under direct threat and France first, Germany second can be downgraded, which can only be a negative outcome that will have unpleasant implications.

This is most probably true if we take into consideration a series of flaws in the institutional and market structure of the euro. Highlighting two of the most important of these flaws, I must remind you that first of all the euro area does not have a surplus redistribution mechanism (fiscal transfers) that would prevent or minimize the occurrence of asymmetric shocks and would ensure converge of the constituent economies of the euro and balanced growth (exactly the opposite of what we actually had all these years and we witness its dramatic impact today).

The other major issue is the quasi-bankrupt European banking sector. A banking sector that was never cleansed of its toxic assets, that has been overloaded with more toxic waste and which is composed of numerous parasitic, zombie banks. A banking system that is incapable of providing sufficient liquidity to the economy, since most of the money that private banks get goes for their recapitalization and only a slight margin is actually reaching the real economy.

These are signs that the ground upon which a joint eurobond will be placed are very unstable. For this project to take material form, the European banking system must be cleared of all its toxic waste, while the system’s debt must be restructured in its entirety. In other words a bottoms up restructuring and debt reduction is required before any sort of joint eurobond is launched.

If this is not done, for whatever reason that may be, the contagious elements of the system will remain in place and will contaminate the eurobond, thus making it toxic in itself.This means that the crisis will eventually reach the core of the system.

I deeply believe that the introduction of a joint eurobond is the only way forward for European leaders who wish to keep the euro in tact and with all its members (since any exits would have catastrophic implications). However for it to be effective and not counter-effective as was – and will continue to be if not redesigned – the EFSF, an audacious restructuring and reduction of the system’s debt is necessary.

At this point with so little information available I would not like to expand into further detail. These however are some principal concerns that I have and I am sure are shared by quite a few.

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